Audit Failure: It’s Time to Address the Cause

We asked ourselves – doesn’t serving a client where standing on principle could be severely punished create a conflict of interest? We concluded then – and I believe now – that it does.

Emerson’s Professional Opinion, January 2002.

The bankruptcy of Enron has caused focus – yet again on the role and performance of the accounting and auditing profession. With this latest failure, the actions, motives, judgment and competence of the profession is being questioned. The issue of auditor independence is again raised. The cry once again is for more regulation and oversight to prevent similar occurrences from happening.

Mitigating the risk of audit failure requires solutions that address the fundamental cause. The Securities and Exchange Commission recently proposed yet another Supervisory Entity to regulate the accounting industry. His actions are well meaning. Unfortunately, this entity will fail to protect the public – just as the Public Oversight Board has apparently failed – unless we rethink its scope and the processes it will oversee. We must also align the processes by which the S.E.C. and the auditing firms fulfill their fiduciary responsibilities.

Critics of the profession specifically ascribe this lack of independence to auditing firms providing consulting services. This is a convenient, but unsupported, culprit. Never, in my 30 years in the profession — including the period from 1993 to 1998 when, as the Vice Chairman of Business Assurance for Coopers & Lybrand, I was responsible for our audit practice — did I become aware of any instance of audit objectivity being influenced by a consulting relationship. Nor, to the best of my knowledge, has any evidence of such influence ever been published with respect to any auditing firm.

The independence issue results from the client firm relationship. Revenues come from the clients to whom services are provided. Fortunately, most clients are only too willing to comply with appropriate accounting and disclosure principles.

What if the client is not so inclined? Suppose the client becomes aggressive in pursuit of short-term results? There is latitude in the application of generally accepted accounting principles – and more in disclosing highly complex transactions. The environment is not black and white. It is gray.

Herein lies the problem. It is not unknown for Registrants to play one firm off against another in search of support for questionable accounting. The implied threat to the incumbent is obvious. Play ball or get fired. We asked ourselves – doesn’t serving a client where standing on principle could be severely punished create a conflict of interest? We concluded then – and I believe now – that it does.

We decided to eliminate this conflict of interest.

We began by firing unacceptably high-risk clients. We then elevated the resolution of professional disputes to levels commensurate with the risk. This had a positive effect upon independence. No longer could client pressure threaten the career of local partners.

We considered this a major risk management initiative. We wanted our clients, potential clients, our people and the business community in general to know that we were serious about our commitment to quality. In an April 25, 1997 article, “More Accounting Firms Are Dumping Risky Clients”, I was quoted in The Wall Street Journal saying —

“All the Big Six firms have taken dramatic, aggressive steps to mitigate risk in their client base. A sterling reputation matters more to us now … so we no longer have certain clients and I’m proud of it”.

We then established stringent criteria for client acceptance. Fundamentally, they had to be free of virtually any business risk. Waivers could be requested. Virtually none was granted. One criteria was not subject to waiver: We would not accept as a client any Registrant that had been fired by – or had fired another firm — over a professional dispute.

It then occurred to us. If we were unwilling to accept such clients, why should the other firms? If none of us would accept them, their only alternative would be to clean up their act. The beneficiaries would be those who rely upon the integrity of the markets. These are the people we seek to protect.

Our risk management procedures were becoming the industry standard. In a New York Times June 29, 1997 article, “Why Some Auditors Like The Taste Of Leftovers“, I was paraphrased as “… taking a much tougher stand (than other firms with respect to accepting fired clients)”. The article acknowledged that we had fired a net of 44 clients, the most of any firm they studied.

That did not begin to tell the story. Our decisions resulted in our firing, being fired by or refusing to accept almost $30 million of client business, mostly from S.E.C. Registrants. The resources were used to generate approximately $50 million of relatively risk free business from current and new ethical clients.

An opportunity was lost when the other firms did not follow our example. Fortunately, it still exists. Here is what must be done, cooperatively, by the auditing firms, the S.E.C. and the new Supervisory Entity – with the support of Congress – to restore the credibility of the audit process.

The Big Four

The senior partners must stop managing the firms and start leading them. They must evaluate client risk, and act accordingly. They must ensure that no partner is in position to put the firm and shareholders of the client at risk.

Firm leaders must confront client management and Audit Committees regarding unacceptable accounting or disclosure. They must not accept any Registrant as a client who has fired – or been fired by – another auditor over a professional dispute. With the risk of being fired mitigated, the profession’s ability to enforce compliance would rapidly improve.

The Securities and Exchange Commission

The S.E.C must approve audit firm replacement. Registrants would be required to demonstrate reasons, other than professional disputes, as a basis for such replacement. Consider the effect. How often would Registrants convince the S.E.C., in the face of auditor evidence, that replacement was warranted?

Supervisory Entity

The members of the Supervisory Entity should have sufficient understanding of the audit process to make informed judgments. The relationship with the firms need not be adversarial. The problem is overly aggressive Registrants – not the auditing firms.

Supervision should include monitoring of the processes by which audit firm client acceptance and professional dispute decisions are made. They should review the S.E.C. audit firm replacement decisions.

They should monitor the profession’s peer reviews to ensure that client acceptance and professional disputes processes are established and monitored, and that issues raised are appropriately resolved.

Congress

The effectiveness of this initiative rests with Congress. It must resist Registrant constituents who, having – by their actions – denied themselves the privilege of major firm audit, will seek relief. In refusing to provide it, Congress will demonstrate that the opinion of an auditing firm is not a right to which every Registrant is entitled. It is a privilege to be earned by adherence to generally accepted accounting principles. Congress must also provide the S.E.C. the resources needed to fulfill its responsibilities.

Registrant Boards of Directors

Audit Committees must recognize their responsibility in ensuring appropriate financial reporting. They must understand the complex transactions proposed by management. They must insist upon appropriate accounting and disclosure. They must demand internal controls to ensure compliance with corporate ethics. They must ensure that professional disagreements are addressed timely and effectively.

The profession, the S.E.C. and the public, with the support of Congress, can demonstrate to Registrants so inclined that the investing public is no longer going to tolerate their subtle, yet substantial influence upon professional decision making. We have the most credible capital formation process in the world. It depends upon the intelligence and moral courage of its guardians – the auditing firms – to function effectively.

While holding them accountable, we must stop treating them like the problem and help them become the solution.